NEWSLETTER 332 EDITORIAL September 2017

Sep 27, 2017

Editorial

Case Study: Hedge Effectiveness of an FX Shark Forward under IFRS 9

With an upgrade from IAS 39 to IFRS 9 in the accounting, one question for exporters and importers that comes up is how to pass standard structured forwards through hedge accounting. The upshot: it is possible: it requires less calculation, less quantitative assessment, but more essay writing and a documentation check list. Not surprising – the rules have been designed by lawyers.

We consider an example where party A is exposed to an appreciating USD relative to EUR. Although the entity wants to hedge against an increasing EUR/USD rate, it wishes to be flexible enough to participate in favorable exchange rates. The entity is willing to accept an exchange rate below the outright forward rate as the worst case scenario. To hedge this FX exposure, A may enter into a shark forward plus with the terms shown in the following table:

Spot reference

1.0800 EUR-USD

Outright forward reference

1.0700 EUR-USD

Party A sells, bank B buys

USD 100,000,000

Settlement

Delivery

Maturity

6 months

Worst Case

1.0800 EUR-USD

American style trigger

1.0500 EUR-USD

Premium

0.00

Generally, the shark forward plus (also called forward plus, forward extra, enhanced forward or forward with profit potential) is suitable for entities that want to fix a forward price while they can still benefit from a spot movement in which they take a view. This type of instrument provides some potential for limiting possible losses with the level near the forward rate. On the maturity day, party A sells USD 100 M to bank B. The exchange rate applied depends on the path of the spot during the time till maturity. The following scenarios are possible at maturity:

If the spot at maturity is above 1.0800 EUR-USD or if the trigger 1.0500 EUR-USD has been breached during the lifetime of the contract, party A sells the notional at the worst case of 1.0800 EUR-USD.

If the spot at maturity is between the trigger rate of 1.0500 EUR-USD and 1.0800 EURUSD, and the trigger of 1.0500 EUR-USD has not been breached during the lifetime of the contract, the spot rate at maturity applies.

If the spot at maturity is equal to or smaller than the trigger of 1.0500 EURUSD, the worst case of 1.0800 EURUSD applies.

The shark forward plus enables participation down to the trigger level and guarantees a worst case rate which is slightly higher than the market outright forward rate. If the spot rate at maturity is lower than the trigger level, the entity does not participate in a favorable spot. For a better understanding of this hedging relationship, we summarize some relevant points before we present the minimum documentation requirements.

Hedge Effectiveness

Economic Relationship: The critical terms match. In comparison with a plain vanilla forward, the shark forward plus allows the hedging entity to participate in a favorable spot movement until the trigger is touched. However, the hedging instrument and the hedged item do move in opposite directions.

Sources of Ineffectiveness: If the exchange rate for the evaluation of the shark forward plus changes, the hedging instrument and the hedged item will not move with the same value in opposite directions.

Decomposition: This is about designating the hedging instrument in its entirety or considering the embedded synthetic forward contract separately. The shark forward plus can be treated in exactly the same way as the plain vanilla forward. To date, it is not clear from the standard or the commentaries how exactly the embedded synthetic forward contract could be separated in practice. Therefore, party A chooses to consider the shark forward plus in its entirety.

Qualitative Hedge Effectiveness Assessment: The critical terms match, as in the case of a vanilla option, until the barrier is breached and as in the case of an outright forward contract after the barrier is breached. The probability of breaching depends on the model applied and the probability measure in use. In the worst case, if the spot is lower than the trigger rate, the critical terms are still closely aligned.

Quantitative Hedge Effectiveness Assessment: The instrument’s value is path-dependent. The economic relationship exists (qualitative proof) and at hedge initiation the shark forward plus is fully effective and can be compared with a plain vanilla call instrument at that point. Assuming the spot moves below the trigger rate and causes the instrument to lock in the worst case, the effect for hedge accounting is no different than with an outright forward contract. Using a Monte Carlo simulation for conducting a regression analysis could provide details about the prospective hedge effectiveness. As a deviation of 1% could make the hedge ineffective, a Monte Carlo simulation could offer more exact values. However, this calculation would not necessarily give any added value in proving hedge effectiveness for this product under IFRS 9. The hedge ineffective part of the relationship between the hedged item and the hedging instrument can be calculated via the dollar-offset method in exactly the same way as with a plain vanilla call option. If the auditor is not clear about the worst case effect and the impact on P&L, a scenario analysis could help a better understanding of the best and worst case valuation to determine how much the movements could impact P&L. If the auditor sets a bright line for risk management, assuming 65-140% (which is 80-125% under IAS 39), no Monte Carlo simulation is necessary in the first place. The dollar-offset method in combination with the worst case scenario could give a result. If the dollar-offset method were to result in 60%, party A could first think about setting a trigger at a more favorable level or could continue quantitative testing with IAS 39 using a Monte Carlo simulation. In my opinion, the minimum requirement does not include a quantitative hedge effectiveness assessment. Using the dollar-offset method to calculate the ineffectiveness satisfies the minimum requirement and could be complemented by a scenario analysis for the worst case.

Minimum Documentation Requirements According to IFRS 9

We now present the minimum documentation requirements for the shark forward plus. The same would apply to a vanilla USD put option, except for the passages highlighted in bold.

Risk Management Strategy and Objective for Undertaking the Hedge: The FX risk management strategy is to decrease P&L volatility. The hedging instruments to be used are options and forwards (with and without participation). The risk management objective is to protect against an increase in EUR-USD of the highly likely sale of a machine for USD 100 M. The risk management objective is in line with the risk management strategy.

Type of Hedge: Cash flow hedge

Nature of Risk being Hedged: FX exposure

Identification of the Hedged Item: USD 100 M sale of a machine expected to be delivered on 30 June and to be paid for on 30 June. The forecast sale being highly probable, the contract is signed on 1 January and the hedge is started on 1 January. The liquidity of the entity is guaranteed to finalize the machine on time and the customer has a consistent previous history of paying for similar-sized machines. The entity is able to produce the machine by its expected delivery date. For the avoidance of doubt, the ensuing receivables will not be part of the hedging relationship. The hedged item is eligible for hedge accounting.

Identification of the Hedging Instrument: The FX shark forward plus contract is a derivatives instrument. The main terms of this contract are a notional of USD 100 M, a 1.0800EUR-USD worst case, a 1.0500 EUR-USD trigger and a six-month maturity. The term sheet and/or deal confirmation should be enclosed to simplify the documentation. The counterparty to the shark forward plus is bank B. The credit risk associated with this counterparty is considered to be very low. The hedging instrument is eligible for hedge accounting.

Hedge Effectiveness Assessment: Party A performs the hedge effectiveness assessment at hedge inception, at each reporting date and when the circumstances of the hedging relationship change significantly. To assess whether there is an economic relationship between the hedged item and the hedging instrument, a qualitative assessment is always performed supported by a scenario analysis. The critical terms method is applied. The critical terms of the hedged item and the hedging instrument match. In the worst case scenario of the hedging instrument,the critical terms are still closely aligned. The credit risk of the counterparty of the hedging instrument will be continuously monitored. The hedge’s effective and ineffective parts will be determined by comparing changes, from the start of the hedging relationship, in the fair value of the hedging instrument to changes in the fair value of a hypothetical derivative. The terms of the hypothetical derivative will be equal to those of the forecast cash flow. The effective part of the hedge will be booked into other comprehensive income (OCI) and reclassified to P&L when the cash inflow of the hedged item takes place which is accounted for in P&L. The ineffective part of the hedge will be recognized in P&L. The forward points of both the hedging instrument and the expected cash flow are included in the assessment.

Overall Assessment

The hedging relationship was considered effective as all the following requirements were met:

There is an economic relationship between the hedged item and the hedging instrument as the critical terms (nominal amount, maturity, and the underlying) match. Based on the qualitative assessment, supported by a scenario analysis, party A concludes that the change in fair value of the hedged item is expected to be substantially offset by the change in fair value of the hedging instrument. This result affirms that the hedged item and the hedging instrument generally move in opposite directions.

The effect of credit risk did not dominate the value changes resulting from the economic relationship as the credit ratings of both party A and bank B were considered sufficiently strong.

The 1:1 hedge ratio of the hedging relationship is the same as that resulting from the quantity of the hedged item that party A actually hedges and the quantity of the hedging instrument that party A actually uses to hedge that quantity. The hedge ratio is not intentionally weighted to create imbalances and hence ineffectiveness.

Advantages

Zero cost structure

Guaranteed worst case

Participation in favorable spot movement

Easy handling for hedge accounting

High offset possible

Disadvantages

Limited participation in favorable spot movement

Worst case less favorable than the market outright forward rate

Conclusion and Outlook

E&Y states[1] that, under the new standard, hedge effectiveness testing will be simpler as it will only be required on a prospective basis. In comparison to IAS 39, IFRS 9 does not require retrospective testing and in general no quantitative hedge effectiveness testing; there is no challenge to demonstrate effectiveness within a defined quantitative band. In particular the IAS 39 tolerance band of 80-125% no longer applies. The requirement is to demonstrate an economic relationship between the hedged item and the hedging instrument with consideration of credit risk and that the designated hedge ratio is appropriate. The cases made clear that more qualitative documentation is required. There exist exceptions for more complex hedging instruments with potentially unlimited losses where quantitative methods are useful. There have been some suggestions that IFRS 9 only requires qualitative testing, but this is not confirmed as the entity always needs to use the dollar-offset method to calculate the ineffective part. In particular, the fact that the bright line and obligatory quantitative testing have been, more or less, abandoned is a great incentive to get more instruments qualified under hedge accounting. As seen in the example of the shark forward plus, it would be easier for even a barrier product or a structured and exotic product in general to achieve hedge effectiveness under IFRS 9 than was the case with IAS 39. With IFRS 9, only the fair value changes and the ineffective part need to be calculated.

This case study[2] and some more on hedge accounting are also contained in the second edition of my book on FX Options and Structured Products[3].

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